As a small business owner, understanding basic financial terminology can help in several ways. For one, you’re going to have to speak some of this language to answer financial questions about your company that are bound to come up sooner or later with an investor, partner, accountant or auditor. Secondly, getting to know these terms can be like a crash course in business economics, which will make it that much easier for you to plan and understand your business's financial future.
Understanding these terms will give you greater perspective on the financial health of your business:
Assets describe everything of value that your business owns and uses to operate, including supplies, equipment (ranging from machinery to office laptops), real estate and cash.
On the other hand, liabilities include all outstanding debts that your business owes, from long-term loans and bonds to monthly rental expenses and utility bills.
3. Cost of Goods Sold (COGS)
Also called “direct costs,” this term refers to the total cost of all labor and materials required to provide the products or services that your customers buy.
4. Capital Expenditures (CapEx)
This term covers anything you buy for your business that will deliver value over the long term (more than a year). Many of your company’s assets, such as computers, machinery and real estate fall under capital expenditures category. Separating these out from your COGS or direct costs is important to understanding how your company can be profitable.
5. Bottom Line
This important phrase refers to either net income or net profit, which are similar ways of accounting for the amount of money you’re left with at the end of the day. It’s the number that appears on the bottom of your balance sheet, hence the name. (The top line is your sales or revenue.) More specifically, net income is your total sales income minus your direct costs, while net profit also subtracts administrative expenses, fees and other overhead costs.
Markup describes how much you add to the direct costs of your product or service to cover additional expenses and make a profit. For example, if your business sells custom T-shirts for $20 each and the cost of a blank T-shirt plus the labor and materials to customize each one comes to $12, your markup for that product is $8.
7. Gross Margin
Gross margin is a broader term that business owners use to track money spent against money earned. It refers to the percentage of your total revenue that ends up as net income (what’s left when you subtract the direct costs) over a certain time. For example, if your company’s revenue is $100,000 in one quarter and your gross margin is 25 percent, then your net income is $25,000. The higher your gross margin, the more of each dollar in sales you can spend on overhead or keep as profit.
8. Profit Margin
Similar to gross margin, profit margin is the percentage of your total revenue that you keep as profit. But to calculate profit margin, you subtract overhead expenses as well as direct costs from your sales and then divide that by your total revenue. Profit is ultimately what makes businesses valuable, but many large and small businesses take time to start generating a profit. This shouldn’t be taken as a day-to-day indicator of your company’s financial health, especially for young businesses.
9. Burn Rate
The term burn rate refers to how much money it takes to operate your business for a period of time, usually a month. It’s especially important to keep track of this figure for new companies because even with the strongest business model, revenue doesn’t always arrive on schedule and you still have to pay bills to keep the lights on. Knowing your burn rate ensures that you have enough cash available to run your business. Experts advise keeping enough money on hand to cover your burn rate for at least six months.
This is an important term for small businesses that have a few big clients. It describes how much of your revenue comes from a specific customer. Businesses that have a handful of customers or partners that generate most of their revenue are considered over-concentrated, which is obviously more risky because losing one customer could have a big effect on earnings. Keeping concentrations low and spread evenly across your customers ensures a balanced foundation for business stability.
Understanding the financial state of your small business is like keeping track of your personal health. You’ll obviously want to consult with professionals, but it’s still good to have a general understanding of where you stand and what to keep an eye on. If you are familiar with the terms listed above, you'll be able to track your business's financial health more effectively. Armed with this knowledge, you'll not only feel more confident as you're analyzing things like your profitability, debt and cash flow, but you'll also be equipped to face any financial challenges that arise as you manage your business.
There may be other terms that you come across when working on financial projects or talking with an accountant. Instead of ignoring unfamiliar terms, take the opportunity to look up the definition and see how they might clarify and expand your understanding of your business.
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